Consider higher capital gains tax before you invest

While attention is currently focused on the possible impact of negative gearing tax changes on property prices, investors also need to consider the impact of higher capital gains tax bills on future investment decisions for all asset classes.

Presumably, future gearing and gains tax changes will apply to all new investments with investments held at the time of the change protected by grandfathering provisions.

Labor's proposals exempt newly constructed real estate from the gearing changes but not from a 50 per cent increase in capital gains tax liabilities. This plan will favour geared investments in newly built properties over the purchase of all other asset classes, including equities, commercial and existing properties.

The significance of this advantage depends on the projected level of capital gains on property prices overall and whether the legislation confines the negative gearing tax benefits to the original purchaser of the new property. Abolishing negative gearing benefits for new investors in existing properties will dampen investment demand for these properties because of the increased after-tax cost of funding the investment and higher future capital gains tax bills.

Having the interest on a part of investment debt non-deductible means that accumulated losses must be funded out of after-tax income in the same way as with owner-occupied mortgage interest. The incentive for affected investors will be to reduce ongoing losses as quickly as possible by reducing debt or increasing tenants' rents.

Without the protection of negative gearing, investment risks will rise substantially, for example, if interest rates rise or the property is vacant for a while. The resulting losses won't be tax deductible until the investment yields a positive return.

Following normal practice, the accumulated losses will be deductible against future income when returns increase but they won't be indexed for inflation. If not claimed against future income, they will be added to the cost base for calculating capital gains, which under Labor's plans will be taxed at 75 per cent of the relevant marginal tax rate.

This tax rate will in most cases be less than the rate used to calculate tax deductions when all expenses are immediately tax deductible. Clearly the proposed capital gains tax changes will reduce the benefit of high gearing levels even if negative gearing still applies. When capital gains comprise a large component of the potential return from an investment, as is the case for residential property, higher capital gains tax bills become a major concern for investors.

Assuming any future tax changes apply only to new investments, investors owning grandfathered assets will be in the box seat to minimise future tax bills. By not selling assets they defer the payment of capital gains tax and retain access to today's lower capital gains tax bills.